Can Hong Kong Cool Off Its Hot Real Estate Bubble?

When it comes to real estate investing, the world never learns: It keeps making the same mistakes over and over again. If you look at the major financial crises of the last several decades, borrowing money to build and buy offices and houses in overheated markets has almost always been a factor. Even now, as the IMF is moving to stabilize an Irish economy that imploded thanks to its own real estate bubble, overbuilding and property inflation threaten to damage Hong Kong and mainland China.

Perhaps that's why authorities in Hong Kong are now trying to put a cap on its real estate bubble by raising taxes: Stamp duties of 5% to 15% on real estate transactions involving properties resold within two years of their purchase are expected to cut deal volume by 30% or more. But it's probably too late to stop the inevitable crash in the Chinese real estate market -- an outcome that would yield another big win for Enron short-seller Jim Chanos.

The situation in Hong Kong real estate is depressingly familiar: Capital has been escaping mainland China in search of a place to earn returns better than the negative rates that Chinese savers can get in bank accounts, but without the extreme volatility of its stock market. Plenty of that capital has been flowing into Hong Kong property and boosting prices -- 15% between January and September 2010, after a 30% spike in 2009, reports the The Wall Street Journal.

Hong Kong is worried that this price rise is going to create a bubble, even though, as a source in Hong Kong's real estate market tells me, the risk is limited because investors there usually put 50% down when they buy.

Is such a collapse possible? One certainly happened in Dubai. As I wrote on DailyFinance in February 2009, that small Middle Eastern emirate is home to huge numbers of empty buildings financed by too much borrowing. And Monday, Ireland appeared poised to accept a $109 billion to $123 billion bailout from the European Union and the IMF after its own real estate bubble burst.

Such a bubble also caused the economy of Japan to enter a 21-year funk after 1989, when its 284-acre Imperial Palace was thought to be worth more than the state of California. And let's not forget the much smaller, but still significant, collapse of oil-patch real estate back in 1982. As I wrote on BloggingStocks in September 2007, that event -- fueled by real estate lending during an oil boom -- resulted in a banking implosion that drew me to the FDIC, where I helped build a system to assist with the cleanup.

Closing the Barn Door After the Cows Have Escaped?

Hong Kong's latest strategy to cool off its real estate bubble is to raise the stamp tax, a levy on property transactions, in a way that will make it harder to flip real estate rapidly for quick profits. The stamp duty will rise to 15% on "property sold within six months of purchase, 10% for those sold within six and 12 months, and 5% for those sold between one and two years." The reaction to the move was swift: Asking prices started falling -- 3% to 5% just this past weekend.

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Over the next three months, transaction volume could fall 30% to 50%, according to the Journal, as the new taxes reduce the flow of hot money from mainland China. This hot money -- which gets around mainland Chinese regulators -- had enabled citizens of the mainland to obtain Hong Kong residency if they invested at least $838,000 in Hong Kong assets, according to the Journal. But in October, Hong Kong excluded real estate from this system. As a result, those mainland Chinese seeking Hong Kong residency as well as a boost in the value of their holdings will have to find a different asset class to invest in.

As much trouble as may be brewing in Hong Kong's property market, the real estate bubble may be far more dangerous on the Chinese mainland. As Fortune reports, Chanos is betting a portion of the $1 billion he has under management on that outcome, because China is building more real estate than its people can live in. Specifically, China is building 30 billion square feet of new construction, and much of it is empty. That's because mainland Chinese -- such as one Shanghai investor cited by Fortune who owns 43 vacant properties outright -- buy real estate as "an investment."

Simple Lesson, Hard to Learn

If all Chinese investors purchased these properties with no borrowing, then a collapse of their value would have limited ripple effects. Unfortunately, Chinese banks -- such as the huge China Merchants Bank -- have backed so-called Local Government Funding Vehicles (LGFVs) that account for 11% of real estate loans on the mainland. So, yes, Chinese real estate investors are borrowing money to buy property, and if those investors can't pay the interest on their loans, the Chinese banking system could be at risk.

Victor Shih, a Northwestern University professor, concluded in a 2010 study that these LGFVs accumulated $1.6 trillion in new debt from 2004 to 2009. As Chanos points out, China's bank regulator is now trying to restrict local borrowing because it believes that 26% of its outstanding debt is "high risk."

The lesson is as simple as it is impossible to teach: Just because you can borrow money doesn't mean you should. The laws of supply and demand always kick in. And when they do, they deliver a swift and painful kick to the host country's economic groin.